Final answer:
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate of return, the company's beta, and the market risk premium. The Weighted Average Cost of Equity (WACC) is a measure of the average cost of capital for a company, considering both the cost of equity and the cost of debt.
Step-by-step explanation:
Cost of Equity using the Capital Asset Pricing Model (CAPM)
The cost of equity refers to the return required by equity investors in a company. The Capital Asset Pricing Model (CAPM) is a widely used method to calculate the cost of equity. It is based on the idea that the return on equity is a function of the risk-free rate of return, the company's beta, and the market risk premium.
CAPM formula:
Cost of Equity = RF + (β x (RM - RF))
- RF = Risk-free rate of return
- β = Beta, a measure of the stock's volatility compared to the overall market
- RM = Expected return on the market
Weighted Average Cost of Equity (WACC)
The Weighted Average Cost of Equity (WACC) is a measure of the average cost of capital for a company, taking into account both the cost of equity and the cost of debt. It is calculated by weighting the cost of equity and the cost of debt by their respective proportions in the company's capital structure.
WACC formula:
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
- E/V = Proportion of equity in the capital structure
- Re = Cost of equity
- D/V = Proportion of debt in the capital structure
- Rd = Cost of debt
- Tc = Corporate tax rate